The cause of the subprime crisis

The subprime crisis was caused by regulation and the expectation that some companies were too big to fail – that if those companies got in trouble, the government would make sure their debtors were paid.

What did regulation tell financiers about subprime loans? It told them they had better make subprime loans, or face a lawsuit by ACORN, a lawsuit in which the regulators made it clear they would be backing ACORN.

Ted Day tells us what regulation said

The Boston Fed, speaking for the entire fed, declared in 1992 “discrimination may be observed when a lender’s underwriting policies contain arbitrary or outdated criteria that effectively disqualify many urban or lower-income minority applicants.”

Some of these “outdated” criteria included the size of the mortgage payment relative to income, credit history, savings history and income verification. Instead, the Boston Fed ruled that participation in a credit-counseling program should be taken as evidence of an applicant’s ability to manage debt.

So yes, starting in 1992, the regulators COMPELLED financiers to make these toxic loans that sunk the world’s financial system.

Indeed, this is natural and predicable, it is inevitable that regulation will always be counterproductive, will always have the opposite effect to that intended, for government regulators have no incentive to be prudent, whereas lenders do have an incentive to be prudent – unless they are lending to a firm that is too big to fail.

If a firm is too big to fail, people will lend it money, knowing the government will ensure they get paid back. So the too big to fail business borrows unreasonably large amounts of money, and lends it in unreasonably risky ventures – if things go well, the too big to fail business pocket the profit, if things go badly, someone else (usually the taxpayer), loses the cash, heads I win, tails someone else loses.

So the government has to regulate too big to fail businesses to restrain them from taking excessive risks – but such regulation is always politically unpopular, for it invariably means that people who “need” credit don’t get loans, and instead loans go to people who don’t need them – that loans go to people with plenty of assets and a history of using money profitably and paying their debts as and when they fall due, which people are seldom popular – goes to wealthy Jews instead of poor blacks, goes to the financially prudent instead of the politically connected, goes to the industrious and thrifty instead of ward heelers who get out the vote. So in practice, regulation aways works the other way around – encouraging or compelling too big to fail businesses to take excessive risks, rather than restraining them from taking excessive risk.

As it did this time.

The more government is involved in business, the bigger the losses are, and because government is more involved in business that it was, the losses were bigger this time.

This entry was posted on Monday, October 20th, 2008 at 6:22 pm and is filed under economics. You can follow any responses to this entry through the RSS 2.0 feed.
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